Contract Workers vs. Employees: What Your Business Needs to Know

Many U.S. workers are forgoing the traditional office job to work on a contractual or freelance basis. For employers, having contingent workers could mean a savings of time and money, as they don't have to take the time to train the worker, pay health benefits or contribute to a 401(k).

However, if your business does choose to use contractors or freelancers, you need to make sure your workers are properly classified. Depending on the specific terms of your arrangement with an independent contractor — hours worked, reporting structure, payment schedule, etc. — you might find yourself in the middle of a misclassification lawsuit.

Joy Child, vice president at law firm Alexander, Aronson, Finning & Co., noted that a company wrongly treating its workforce as independent could be liable for payroll taxes, interest and penalties. Regular employees are entitled to certain legal protections and benefits that independent contractors aren't, and the IRS and state governments are actively looking for clues that a company might be shirking its responsibilities to its workers. [See Related Story: Outsource or Hire? How to Decide What's Right for Your Business]

How are independent workers classified?

In the 1990s, Microsoft misclassified thousands of programmers and computer engineers as independent contractors. These long-term temp workers brought a benefits case against the company and were deemed by the courts as "employees." As a result, the company was required to pay $97 million in penalties and legal fees, and the case yielded a set of guidelines to help employers determine whether a worker is an employee or an independent contractor.

Control over how work is done: Workers who work when and where they want, using their own methodologies and guidelines, are rightly considered to be independent contractors. If, however, you require a worker to be in the office for a fixed period of time and work according to company policies, that person should likely be classified as an employee.

Equipment and software: Does the worker use his or her own computer, or does he or she use a machine on-site? Does that machine have software on it that the worker does not have? Does he or she use company office supplies? An independent contractor should supply most or all of his or her own materials to complete a job.

Compensation: Freelancers are generally paid by the job. If a company pays a worker a monthly or yearly amount, the IRS will likely categorize that person as an employee. Remember, businesses need to send all independent contractors a 1099 form to report how much the company paid the person over the course of a year.

Training: Businesses shouldn't have to train independent contractors, according to the IRS and many state labor boards. Independent contractors should be able to begin immediately, producing work that they've been hired for. If a worker requires significant training, he or she may be considered an employee.

Exclusivity: True freelancers are self-employed business owners. They often have their own website and business cards, and advertise their services to other companies. Asking the person to exclusively work for your company puts him or her closer to employee status.

Some lawyers routinely advise businesses to cease using independent contractors, or to reclassify them as employees, to avoid the potential for misclassification liability. An updated version of the report details steps companies can take to minimize or avoid future misclassification issues.

If a compliance analysis reveals potential misclassification issues, workers can be reclassified as either employees or independent contractors. This can be done either by a government reclassification program or voluntarily. This does not require that independent workers who are now employees become part of your benefits program, though; voluntary participation is likely to be more cost-effective and less painful for businesses.

Once everything is restructured, the accompanying documents must ensure that the contractor agreement is followed, according to the report.

There are workforce management and staffing organizations that hire or retain some or all of a company's independent contractors, and they issue those workers a 1099 (independent worker) or a W-2 (employee) based on their proper classification. Miranda Nash, co-founder and CEO of talent marketplace Qeople, advised employers to work with one of these firms to reduce the administrative burden.

Although using these firms doesn't free employers from liability, staffing agencies can help because they are familiar with the rules and how to manage contract and freelance workers, Nash said.

In a recent webinar by Work Market, co-founder and president Jeff Wald said "a lot of people still have a lot of guesswork" when it comes to determining the compliance of their contingent workforce, and that "60 percent of all contingent labor is unaccounted for in financial planning and forecasting." The above outline could help take the guesswork out of how to use contingent workers, and help avoid any potential misclassification liability.

For more information on worker classification, see the IRS website's resources on Form SS-8.

Additional reporting by Patrick Egan and Nicole Taylor. Some source interviews were conducted for a previous version of this story.

Jennifer Post

Jennifer Post graduated from Rowan University in 2012 with a Bachelor's Degree in Journalism. Having worked in the food industry, print and online journalism, and marketing, she is now a freelance contributor for Business News Daily. When she's not working, you will find her exploring her current town of Cape May, NJ or binge watching Pretty Little Liars for the 700th time.